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Taxes and Economic Growth

As the United States tries to dig itself out of the lingering recession – which might well have been a deep depression – we shall hear a lot about two barriers to a speedier recovery: a proposed increase in the long-term capital-gains tax rate and the high corporate tax rate.

Both are likely to play on center stage in the coming election campaign.

Capital-Gains Taxes: A major problem with the tax preference embedded in the taxation of capital gains is that the preference is so scattershot, rewarding both behavior that leads to economic growth and behavior that does not.

As the Internal Revenue Service puts it in Topic 409 – Capital Gains and Losses, “almost everything owned and used for personal or investment purposes is a capital asset.”
If one buys a capital asset and sells it more than a year later, any gain or loss on the transaction is classified as long-term. If the net on long-term capital gains and losses during a taxable year results in a capital gain, it is taxed at a rate below the rate applied to ordinary income from wages, interest and so on.

In 2009, for example, the maximum capital gains rate for most people is 15 percent. A few special types of net capital gains are taxed at 25 or 28 percent (for example, the maximum tax rate on long-term capital gains from the sale of collectibles such as coins and art in 2009 was 28 percent – still much below the highest tax rate on ordinary income).

If Congress does not take any action, these rates are likely to apply in 2010 and are scheduled to increase in 2011.

Whenever proposals are made to raise the tax rates on capital gains, a howl goes up from supply-side economists, who argue that an increase will stifle economic growth and job creation. They assert that the tax would discourage investors from risking their capital on the creation of businesses or the job-creating expansion of existing businesses.

This argument is persuasive as far as direct investments in expanding productive capacity is concerned. It much less persuasive when applied to long-term capital gains on transactions in existing assets, be they outstanding financial securities or real estate, such as residential homes. And it is completely unpersuasive when applied to art or coin collections.

Suppose in 1995 the ABC Company issued and sold new ABC shares and, in 2008, I purchased 1,000 of those shares at $50 a share. If I sold them for $90 a share in 2010, what new productive capacity would I have supported with my investment? The ABC Company surely would not receive my money. The party who sold me the shares might have used the proceeds to buy some other outstanding shares of stock or spent it on consumption items, perhaps even consumption items imported from abroad.

Why, then, should the gains from such a transaction be taxed at a lower rate than, say, the income earned by a pediatrician? In what way would taxing the seller on that gain inhibit economic growth?

And try to defend the favorable tax treatment of investing in a lithograph by Miró or in collections of coins!

Contrast these transactions with a venture capitalist who risks $20 million on an inventor bringing a product to market. Once the product has been developed, mezzanine investors may contribute additional millions to develop a market for the product. Suppose they eventually incorporate the new company and sell shares in an initial public offering, earning several hundred million dollars on the capital they risked. I certainly can see why rewarding these risk-takers with a tax preference would be smart public policy to encourage economic growth.

In short, instead of raising or lowering the current long-term capital gains tax, Congress should consider aiming the tax preference at only those investments in capital assets that directly and powerfully contribute to economic growth and job creation. Mere bets on the movement of prices of already existing assets should be taxed as ordinary income.

Currently, American corporations pay federal taxes of 35 percent on taxable profit – close to 40 percent if state taxes are included. This tax yields about 12 percent of total federal revenues, far below the individual income tax (45 percent) and payroll taxes (36 percent). Yet the tax engages legions of smart accountants and tax lawyers playing a zero-sum game.

Some argue that American corporate tax rates are among the highest in the industrialized world, which is said to induce many multinational corporations in the United States to invest their capital abroad instead of at home.

On the other hand, Treasury Secretary Timothy F. Geithner asserted last week on CNBC that the effective tax rate that American businesses pay is “about average.”

These sharply differing views may reflect the fact that a corporation’s “taxable income” can be much lower than the net income it reports to shareholders. Numerous clauses in the tax code (often decried as loopholes), as well as different accounting standards for taxes and for financial statements, exclude portions of income reported to shareholders from “taxable income.” It follows that the taxes actually paid as a percentage of income reported to shareholders can be much lower than tax rates on taxable income, and in some years even zero for some corporations.

Whether corporate tax rates in the United States are higher than those of other countries strikes me as less significant than the much more fundamental question of whether corporate profits should be taxed at all. Does anyone actually know what set of human beings ultimately pay the corporate income tax?

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